Clothes-makers, food manufacturers, and other businesses who were never involved in the copper or iron ore trade were buying large amounts in China. They did not want it to make anything. They needed it to raise cash
Businessmen and women often are extremely clever in developing various arbitrage schemes. These schemes become especially prevalent during periods of easy credit when lenders are less sensitive about risk. One such scheme has recently had some adverse publicity, commodities financing in China.
Often, the creativity of borrowers is inspired by regulations. This was true in China in 2010. China is the world’s second largest economy and accounts for about 40% of the global demand for copper. Copper is relatively valuable, simple to store, transportable and does not deteriorate. As such it is perfect to use as collateral. In 2010, the Chinese government was involved in one of their periodic curbs on credit excesses. This put a lot of businesses in a quandary. Clothes-makers, food manufacturers, and other businesses who were never involved in the copper trade were buying large amounts. They did not want it to make anything. They needed it to raise cash.
The process went like this. They used funds as collateral to get a letter of credit (L/C) from their bank. They used the proceeds of the L/C to buy copper. The copper could then be sold or used as collateral for more loans. The owners could use the proceeds for operations or more often they would make loans at higher interest rates to someone who needed the money more. The L/C did not have to repaid for 90 days at a cost of 30 basis points or 180 days for 70 basis points. In that period, traders could invest in the shadow banking products and earn a return of over 10%.
The business community liked the trade because it provided credit and could make quite a bit of extra money. The banks liked to issue the L/Cs because the transaction was off the balance sheet. They could use the collateral put up for the L/C to make more loans and the bank clerks who issued the L/C received a commission.
Again the regulations changed. The People’s Bank of China (PBOC) tried to reign in this scheme. They required the banks to put the original collateral held against the L/C into a low yielding reserve account. While this did not prohibit the transaction, it did make it less profitable for the banks. So the traders adapted. They went off shore.
This had several advantages. Thanks to the US Federal Reserve, dollar loans were cheap. They could use the proceeds of the L/C to make yuan loans at higher rates. So the arbitrage with copper went on.
Not only did traders use copper to provide financing, the scheme spread to imported iron ore. Iron is not really ideally suited for this type of trade, but China has a large over capacity in steel making and the demand is slowing. The mills need the money. So they turned to commodities financing. They did this until the China Banking Regulatory Commission (CBRC) put pressure on the banks to increase lending requirements. Iron ore futures contracts dropped 5%, the largest drop since the contracts were introduced in October 2013.
Borrowing off shore in Singapore and Hong Kong adds another layer to the risk. The scheme has enough of that already. There is commodity risk. The value of the copper could go down during the period of the L/C. There is interest rate risk. As the iron example shows there is substantial regulatory risk in China. When the transaction is offshore there is foreign exchange risk too. While the yuan was appreciating this did not seem like a problem, but its recent fall brought the risk into focus. Perhaps the most dangerous is information risk. The trade distorts information about the copper market. It distorts the export numbers and distorts the loan numbers.
These risks would have been dangerous enough, but the most recent risk put the others in perspective: fraud. To get financing the owner of the copper had to have a receipt from a bonded warehouse, a piece of paper. Sometimes this receipt was issued ten times, allowing the trader to secure ten loans for the same collateral.
Of course, all good things must come to an end. Recently one of China’s largest enterprises, the state owned financial firm, CITIC, became suspicious and asked a court in the port city of Qingdao to give it access to the collateral held in warehouses. The possibility of fraud not only in Qingdao but also in the port of Penglai sent chills down the spines of loan officers not only in China, but also several foreign banks including Citigroup Inc., Standard Chartered PLC, Standard Bank PLC, ABN Amro Bank NV, BNP Paribas SA and Natixis. It also impacted the price of copper, which dropped 4.5% on the London Metals Exchange.
Some commentators have dismissed this issue as a one off small risk. After all only 2% of refined copper arrives in Qingdao. Most of it arrives in Shanghai where standards are theoretically higher. If this one case of fraud were all that there was to worry about, they would be correct, but it isn’t.
The issue is much greater because it represents several major issues regarding the Chinese financial system. First are the lengths that businesses will go to, for access to credit at almost any price. Second is the ease of avoiding an uneven regulatory system. Finally it illustrates issues with information in China.
Commodities financing is not just about copper and iron. It also takes place for gold, aluminum and even foods like soybeans and palm oil. According to Goldman Sachs commodity financing could account for as much as $160 billion, or about 30%, of China’s short-term foreign-exchange borrowing.
Commodities financing like other debt schemes in China is intimately connected with the shadow banking system. For example, money from commodities is sometime reloaned to developers in a real estate market that is slowing. The fall of one domino could reverberate throughout the system. The Qingdao issue may be small, but it represents standards of lending throughout China.
It is a question of risk. In the present loose money environment that permeates the entire global financial system, lenders ignore it. They are very lax when it comes to risk assessment, especially if there is any reasonable yield. They tend to overlook or waive the legal safeguards normally used to protect themselves. If these loans go bad, the probability of attaching the collateral in most emerging markets is exceptionally difficult even if there isn’t any fraud. In developed markets, covenant lite or cov-lite lending has reached record levels, higher than in 2007. Lenders, even when they could avail themselves of protection, don’t require it.
If banks or other lenders start to ask questions they are likely to tighten up on lending. Since many businesses and even local governments in China are sitting on a pile of debt, failure to access even more credit will feed on itself. Fear of being the last creditor to attach collateral is just the first step.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)